It took decades for behavioral economics to break into the mainstream. Now, after just a few years of “bias,” “anchoring” and “nudge,” some critics are already questioning whether it has anything left to offer.
This is a curious suggestion. Behavioral economics might well be open to ill-informed accusations of relying on easy wins, but so it goes in many scientific disciplines. Challenging and refining findings is essential to how we progress, which is why relentless experimentation – the signature research method of behavioral economics – is the very foundation of science.Make no mistake: behavioral economics is an experimental science in action. The perception of economics as non-experimental endured for most of the 20th century, sustained by the beliefs and pronouncements of figures as influential and as decorated as Milton Friedman, but nowadays many economists – not most, granted, but many – do run experiments.
What do these experiments actually tell us? Perhaps the single most important inference, one that’s demonstrated again and again, is that we need to invest in developing theories of behavior that are built on evidence about how people make decisions rather than on age-old assumptions about how idealized hyper-rational beings ought to choose.
The ultimatum game
The simple fact is that we’re not super-rational, selfish optimizing machines. Conventional economics has traditionally proceeded as if we are, but experiments to test predictions of economic theory have regularly disputed these cornerstones of long-accepted wisdom. This central idea is one that a layman can grasp with comparative ease, which is of no mean merit in an age when individuals are being urged to take more responsibility for their own financial affairs.
We can demonstrate as much very simply. Consider the ultimatum game, which ranks among the most uncomplicated and yet most revealing little experiments in the whole discipline.
The game involves two players, the first of whom is given a sum of money – say, £10 in £1 coins – and invited to propose a share to the second. The money is shared as agreed if the proposal is accepted, but neither player receives anything if the proposal is rejected.
The standard theoretical prediction is that the first player will make the smallest possible offer to the second – £1 – and the second will accept. By the same token, if the £10 were in pennies the first player would offer 1p and, again, the second player would accept.
It sounds silly, if not even hopelessly unrealistic, doesn’t it? But that’s what traditional theory implies. It assumes that both players are calculating optimizers who prefer more money to less and care only about their own pay-offs. On that basis, the first player will figure that the second would accept any positive amount. So it’s optimal for the first player to propose giving up the smallest possible amount expecting that the second, also a rational coin-maximizing machine, will accept it.
So much for theory. In reality, as numerous experiments have illustrated, very few ordinary people actually offer the absolute minimum, and when they do, their derisory offers often get rejected. Most actual proposals are pitched somewhere between a third and a half of the total, and it’s by no means unusual for offers of less than a third to be rebuffed (so both walk away with nothing).
To put it another way:
First player: “Hello. Someone just gave me £10 to share with you. How about you take £1 and I keep the rest?”
Second player: “I don’t think so mate, I’ll give up my quid to see you lose yours too pal!”
But if that’s what people do, what explains it? Is it fear of rejection or a noble sense of fairness that influences the proposers? Are those who turn down positive offers blinded by outrage or driven by some sense of injustice or perhaps even plain spite? There are many potential interpretations, but one thing that’s abundantly clear is that our financial decisions are shaped by much more than purely rational considerations aimed at maximizing personal gain.
There are two more general points well worth noting about this game and many others like it, too. First, they teach us something. Second, they’re fun.
But maybe this second point explains part of the current reaction to behavioral economics too. Maybe it’s because we “sell” behavioral economics on the strength of some easy-to-grasp examples that its detractors are tempted to claim it has nothing left to say.
By stark contrast, the truth is that the formal models of behavioral economics – though often motivated by apparently simple psychological intuition – can turn out to be even more complex than traditional economic models. Indeed, standard economics has prized mathematical elegance and simplicity above any concerns about real human reasons or motivations. But as Einstein remarked: “Elegance is for tailors.” And it turns out that, when the theoretical work gets under way in earnest, when you try to dig deeper and understand what’s really at the root of the apparently obvious or simple, behavioral economics can become pretty damned intricate.
When audiences sense that what was once seemingly a breeze is becoming a chore, when they feel that what was previously an engaging doddle is metamorphosing into something that requires long run scientific investment, might they begin to tune out and move on?
This is a threat behavioral economics now faces. No sooner is it finally taken seriously than some people start to fall out of love with it.
This has more the dynamic of fashion than science. A science shouldn’t become uninteresting as it ventures into more challenging territory – quite the contrary. Applying this rule of thumb, we would still believe the Earth occupies the center of the universe and that all matter consists of the same four elements.
The fact is that behavioral economics still has plenty to say. Yes, some of what it has to say might be trickier to digest than the basic insights afforded by the ultimatum game and its ilk; but we would do well to remember that complexity and difficulty are natural corollaries of scientific progress, not a convenient excuse for an undeserved return to the margins.